The Gasoline Price Shell Game

The Chinese coronavirus has put a huge damper on business activity, consumer spending and transportation, especially recreational/discretionary spending and activity. With the lockdown and stay-at-home orders widespread in the U.S. and many other major countries, personal driving and regular passenger car/bus/train/air travel have all declined precipitously. This has dropped the demand for crude oil by millions of barrels per day. The upside is that retail gasoline pricing has fallen and the average driver is quite happy about the new lower prices. He shouldn’t be. He's getting a raw deal.

As world oil demand dropped, Saudi Arabia and Russia -- two of the world’s top three oil producers (along with the U.S.) -- engaged in a cutthroat crude oil price war in early 2020 as each country vied for market supremacy and dominant market share amid a rapidly weakening market. As a result, West Texas Intermediate (WTI) crude oil pricing has fallen from the mid-$60s at the end of November 2019 to the low-$20s at the end of March 2020. The world’s major oil producers -- both OPEC and the bigger independent players -- have recently come to an informal agreement to slash output in an attempt to prop up oil pricing and stabilize those economies that rely primarily on oil for the bulk of their country’s revenue.

It would be useful to review the four main factors that affect world crude oil pricing. They are:
1. Worldwide Supply and Demand
The demand for oil in the U.S. was at record levels in 2019 as our economy cruised along in overdrive. U.S. productivity was way up, the housing and automotive markets were at or near record levels, consumer spending was at an all-time high, the unemployment rate across all demographic groups was at or near historic lows. The demand for oil in the U.S. had never been greater.

2. Exploration and Extraction Activity
When oil entities actively explore for new deposits in “high-percentage likelihood” areas, that activity sends a definite signal to the world’s oil traders that significant new supply is coming on board soon. Likewise, when a new field is discovered, it sends the same signal, even if the actual extraction/production phase hasn’t started yet. Commodity pricing is based in large part on emotion and expectation, and if exploration/extraction activity is high, that exerts downward pressure on pricing because of the expectation of greater supply. The reverse is also true -- if such activity is low (for environmental/political reasons, etc.), then the market operates on the assumption that future supply will be restricted.

3. "Regional" blends of gasoline and Distribution Inefficiencies
Most consumers don't realize that gasoline sold on the coasts or in major metropolitan areas is different than the gasoline sold in rural markets, or that cold-weather gas is different than gas sold in warm seasons. Because of increasingly tougher environmental/pollution regulations, each major climatic region of the U.S. must have gasoline that meets the specific requirements for exhaust emissions. Depending on average temperature, humidity, population levels, existing air quality, etc, the formulations of gasoline vary from region to region. There are multiple such 'boutique' gasolines across the country.

While this might be good for the environment, it is extremely inefficient from an economic standpoint, since energy companies can't readily transfer gasoline inventory from area to area to meet spikes in local demand. Therefore, if there's a shortage of gasoline in metro NY and an excess in Topeka, Kansas, the producer can't shift their stock from Kansas to NY, because Kansas gasoline is "illegal" in NY. Result? A shortage in NY, and a resulting price increase. This wasn't the case before regional blends became law. To make matters even worse, all the different formulations mean that U.S. refineries (which take crude oil and turn it into gasoline) are stretched to their limits, and constantly playing catch-up. There are simply not enough refineries in the U.S. to keep pace with all the new gasolines that are needed and when you throw in the roll-of-the-dice gamble that the refineries must play as to when they convert from producing summer gasoline to winter heating oil, it's no wonder we often don’t have enough of the right fuel at the right time.

4. Geopolitical Instability (aka the “Terror Premium”)
Political unrest contributes to the falling confidence of commodities traders around the world, whether the commodity in question is crude oil, copper, wheat or anything else. Commodity and investment markets are as much about confidence in an uninterrupted supply and reaction to possible future disruptions as they are about any reaction to present-day occurrences. Iran threatening to close the Straits of Hormuz, an attack on Saudi oil facilities, sabotage at Nigerian refineries, are all events that can trigger a worldwide oil price shock. Estimates are that this so-called 'terror premium' adds several dollars per barrel to the price of oil.

That’s how the price of crude oil on the world market is determined. But here is the more interesting and relevant thing, and it’s something that has managed to escape the attention of virtually every pundit, news reporter, politician, and consumer:

The historical relationship between crude oil pricing and the retail gasoline prices in the U.S. is way out of whack and the American public is getting stiffed.

For years, the approximate relationship between the price per barrel of crude oil and the U.S. retail price per gallon of gasoline was in the range from 3 ½:1 to 4:1. (Okay, it was actually oil x .04 = gasoline, but it’s easier in your head to simply do 4:1.) So quite simply, if oil is $40/barrel, gasoline would be $1.60/gallon. (40 x 4 = 160 pennies, or $1.60)

Remember in 2008, when gasoline eclipsed $4.00 gallon? We actually caught a break then, because oil was $140/barrel, which should have translated into a per gallon price of $5.60 (140 x 4 = 560.) No doubt, the oil production/distribution chain tightened its belt and willingly accepted a lower margin in hopes of mitigating the catastrophic damage that $5.00+ gasoline would have had on discretionary consumption. So it peaked at “only” about a national average of $4.08/gallon. Those were the bad old days.

The roughly 3 ½:1 to 4:1 relationship held for quite a while. For example, in Sept 2012, oil was around $93/barrel and gasoline was $3.75/gallon, a relationship of almost exactly 4:1, right where it should be.

But that historic relationship has gotten worse in recent years and the consumer has been the loser.  When oil pricing took a plunge in the 2014-16 timeframe, everyone celebrated the new lower gasoline prices. But crude oil was down to around $35/barrel in those days, which should have translated into gasoline pricing of $1.40/gallon. But it wasn’t $1.40/gallon. Gasoline averaged around $1.80-$2.00/gallon. It may have seemed like low pricing, but that was a relationship of well over 5:1 between oil and gasoline, far more expensive than the long-term historical average of 4:1.

Today it’s even worse. Crude oil is around $23/barrel. Using the 4:1 measure, gasoline should average $0.92/gallon. 92 cents. But it doesn’t -- not even close. Gasoline today averages around $1.80/gallon. That’s a relationship of almost 8:1. What happened to the long-term relationship of 4:1? Where are our politicians on this? The betting here is that these politicians have absolutely no clue whatsoever about any of this. In their chauffeur-driven, expense-account world, they don’t fill their own cars with their own money. The shocking recent change in the historic oil-to-gasoline pricing relationship is coming solely at the expense of the typical consumer. The average person, in his ignorance, is happy about what he thinks is a most gratifying drop in gasoline pricing. But the gasoline-consuming public is getting ripped off.

People need to wake up.